Loading the player...

What is 'Uncovered Interest Rate Parity (UIP)'

Uncovered interest rate parity theory states the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period. If the uncovered interest rate parity relationship does not hold, then there is an opportunity to make a risk-free profit using currency arbitrage or Forex arbitrage.

BREAKING DOWN 'Uncovered Interest Rate Parity (UIP)'

Uncovered interest rate parity conditions consist of two return streams, one from the foreign money market interest rate on the investment and one from the change in the foreign currency spot rate. Said another way, uncovered interest rate parity assumes foreign exchange equilibrium, thus implying that the expected return of a domestic asset (i.e., a risk-free rate like a U.S. Treasury Bill or T-Bill) will equal the expected return of a foreign asset after adjusting for the change in foreign currency exchange spot rates.

There are two types of interest rate parity: covered interest rate parity and uncovered interest rate parity. When uncovered interest rate parity holds, there can be no excess return earned from simultaneously going long a higher-yielding currency investment and shorting a different lower-yielding currency investment or interest rate spread. Uncovered interest rate parity assumes that the country with the higher interest rate or risk-free money market yield will experience a depreciation in its domestic currency relative to the foreign currency.

Uncovered Interest Rate Parity Formula and Example

When UIP holds the following relationship exists:

%Change in expected future spot price S(f)/S(d) = i(f) - i(d)

This equation shows that the expected change in the future spot foreign exchange rate over the same investment period should be equal to the difference in interest rates.

Where:

S(d) = domestic country expected future spot price

S(f) = foreign country expected future spot price

i(f) = risk-free foreign interest rate

i(d) = risk-free domestic interest rate

The return on an uncovered foreign-currency risk-free investment is represented by the following equation:

(1 + i(f))(1 - %change in expected future spot price S(f)/S(d)) - 1

The Total Return is dependent on the future change in the expected future spot rate and can be approximated as:

i(f) ~= %change in expected future spot price S(f)/S(d)

Empirically Analyzing Uncovered Interest Parity

There is only limited evidence to support UIP, but economists, academics and analysts still use it as theory and conceptual framework to represent rational expectation models. UIP requires the assumption that capital markets are efficient. Empirical evidence has shown that over the short- and medium-term time periods, the level of depreciation of the higher-yielding currency is less than the implications of uncovered interest rate parity. Many times, the higher-yielding currency has strengthened instead of weakened.

RELATED TERMS
  1. Covered Interest Rate Parity

    Covered interest rate parity is when the relationship between ...
  2. Parity

    Parity refers to things being equal to each other. It can thus ...
  3. Risk Parity

    Risk parity is a portfolio allocation strategy using risk to ...
  4. Parity Price

    Parity price is a term used to explain when two assets are equal ...
  5. Parity Product

    A parity product is a brand of good that has enough similarities ...
  6. Starbucks Index

    The Starbucks Index is a measure of purchasing power parity comparing ...
Related Articles
  1. Trading

    Using interest rate parity to trade forex

    Learn the basics of forward exchange rates and hedging strategies to understand interest rate parity – fundamental knowledge for foreign-currency traders.
  2. Investing

    Explaining Interest Rate Parity

    Interest rate parity exists when the expected nominal rates are the same for both domestic and foreign assets.
  3. Insights

    Purchasing Power Parity (PPP)

    Purchasing Power Parity (PPP) compares different countries' currencies through a market "basket of goods" approach. Two currencies are in PPP when a market basket of goods (taking into account ...
  4. Insights

    Interest Rate Arbitrage Strategy: How It Works

    Changes in interest rates can give rise to arbitrage opportunities that, while short-lived, can be very lucrative for traders who capitalize on them.
  5. Investing

    Purchasing Power Parity: The Big Mac Index

    In theory, Purchasing Power Parity stands up much better than it does in reality. Find out how to evaluate currencies according to the price of a Big Mac.
  6. Trading

    How & Why Interest Rates Affect Futures

    There are at least four factors that affect change in futures prices, including risk free-interest rates, particularly in a no-arbitrage environment.
  7. Trading

    Forex: Gauging Forex Market Sentiment With Open Interest

    Examining open interest on currency futures can help you confirm the strength of a trend in forex market sentiment.
  8. Investing

    Protect Your Foreign Investments From Currency Risk

    Hedging against currency risk can add a level of safety to your offshore investments. Find out more about currency risk analysis in global investing.
  9. Trading

    4 ways to forecast currency changes

    Whether you are a business or a trader, forecasting currency exchanges helps guide your decisions to minimize risks and maximize returns.
RELATED FAQS
  1. How do I convert a spot rate to a forward rate?

    The spot rate shows the cost of executing a financial transaction today, while the forward rate provides the cost of executing ... Read Answer >>
  2. What are the nations with the lowest PPP (purchasing power parity) with respect to ...

    Learn how purchasing power parity (PPP) is used to compare the price of goods between countries, and which countries have ... Read Answer >>
  3. What is the Difference Between a Forward Rate and a Spot Rate?

    The forward rate is the settlement price of a forward contract, while the spot rate is the settlement price of a spot contract. Read Answer >>
Trading Center